Incentive Complementarity in China's Rural Enterprises

Complementarity between incentive instruments is regarded as one of the central themes of theoretical research in the economics of industrial organization in recent years. However, despite its importance, empirical evidence on the existence of complementarities is limited. In this paper we identify complementarities between incentive mechanisms used by firm-owners to motivate managers. Using a multi-task principal-agent framework we consider a problem in which the owner uses two incentive instruments, profit-sharing and investment-bonding, to motivate the manager in two tasks, production and asset-maintenance. Our theoretical model yields testable hypothesis regarding the complementary and individual effects of incentives on performance. We test the hypothesis of our theoretical model against a dataset on 56 rural firms in China, observed in 1988 and 1995. Our descriptive results clearly show that the two instruments are complements. Our econometric model using a panel regression framework confirms that significant complementarities exist in terms of the impact of the two instruments on performance. In order to evaluate the robustness of our results we account for unobserved differences in firm quality using fixed effects and instrumental variables regressions. Support for the complementarity hypothesis is also found after controlling for unobserved heterogeneity